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How to determine the value of investment property using cap rates and gross rent multipliers. |
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Every thing we need to calculate these three items is contained within the nine lines of the before-tax cash flow model. Of particular interest are Gross Scheduled Income (line 1), Net Operating Income (line 7), Annual Debt Service (line 8), and Before-Tax Cash Flow (line 9).
2. – Vacancy & Uncollected Rents – $ ___________
3. = EFFECTIVE RENTAL INCOME = $
4. + Other Income + $___________
5. = GROSS OPERATING INCOME = $
6. – Annual Operating Expenses – $___________
7. = NET OPERATING INCOME = $
8. – Annual Debt Service – $___________
Two commonly used methods of determining the value of an investment property are the Gross Rent Multiplier (GRM) method and the Income Capitalization or Cap Rate method.
Gross Rent Multiplier
(GRM)
The investment value of a
property can be calculated using the estimated Gross Scheduled Income
(GSI) for year one, multiplied by a factor known as the Gross Rent
Multiplier (GRM). ("Gross Rents" is just another way of
saying Gross Scheduled Income.)
First-year GSI x GRM =
Investment value of property
The gross rent multiplier
used in evaluating investment property is typically derived from
comparable properties in the marketplace and may be adjusted by the
investor to reflect his or her specific requirements.
Using the Gross Rent
Multiplier to Determine Investment Value
Example:
Suppose a
potential buyer's gross rent multiplier (GRM) requirement is 8. (This
means the investor will pay no more than 8 times the gross scheduled
rent to purchase an investment property.) The property the buyer is
considering has an estimated first-year gross scheduled income of
$24,000. The investment value, or the amount this investor would be
willing to pay for this property, is:
$24,000 x 8 = $192,000
Pros and Cons in Using
a Gross Rent Multiplier:
Pros: The
gross rent multiplier is a convenient tool because of its simplicity.
Cons: The usefulness of the gross rent multiplier is limited by the fact that it does not take into account vacancy and uncollected rent, operating expenses, debt service, tax impact, or income past the first year.
Capitalization Rate
(Cap Rate)
The value of an
investment property can be determined by its ability to produce cash
returns. After paying all expenses, except principal and interest
payments, the remaining cash flow is called the Net Operating Income (NOI).
NOI is most commonly used in conjunction with a cap
rate to determine property value.
Cap Rate
The cap rate is the ratio
(expressed as a percentage) between purchase price and the first-year
net operating income (NOI) of the property.
Determining the Cap
Rate of an Investment
Investors use cap rates to
measure investment performance:
Net Operating
Income (NOI) =
Cap Rate
Purchase Price
Example:
An
investment property selling for $200,000 with an estimated first-year
NOI of $20,000 would have a capitalization rate of 10%.
$20,000 = 0.10 or 10%
Using a Cap Rate to
Determine Investment Value
A variation of the cap
rate formula can be used to solve for investment value (price) when
the cap rate and the net operating income are known.
Example
Suppose a potential buyer
is looking at a property listed for $200,000 with an estimated
first-year NOI of $18,400. After looking at the cap rates of similar
properties, the buyer has decided on a cap rate requirement of 9.5%.
We can use the formula below to determine the purchase price he would
be willing to pay.
Income (NOI)
= Investment Value
$18,400 (NOI) =
$ 193,684
Cap
Rate
9.5%
Cap Rate
Pros and Cons in Using
a Capitalization Rate (Cap Rate):
Pros: The
main advantage of using a cap rate is its simplicity. It also accounts
for vacancy and operating expenses.
Cons: The reliability of using a cap rate is limited because it only looks at a one-year forecast and does not take into consideration any financing or tax implications.
Cash on Cash
Another measurement
of investment performance is called Cash
on Cash (C/C). This involves
comparing an investor's initial
investment to the potential before-tax
cash flow an investment property is
likely to produce. Let's assume the investor's initial investment is
$45,000 ($40,000 down plus $3,400 in closing costs plus $1,600 for
points ). We will also assume the property produces a
before-tax positive cash flow of $4,972 per year.
$45,000 (on cash)
Pros and Cons in Using
Cash on Cash
Pros: Cash
on cash takes into consideration vacancy and uncollected rent,
operating expenses, and debt service.
Cons: Cash on Cash does not take into consideration anything past a first-year forecast. It does not take into account tax considerations or any increase or decrease in equity
Debt Coverage Ratio (DCR)
Another use for the
before-tax cash flow model is determining Debt
Coverage Ratio . When providing
financing for apartment complexes with five units or more, lenders
generally use a debt coverage ratio as a lending guideline.
Formula: Debt Coverage Ratio (DCR) is determined by dividing net operating income (NOI) by the annual debt service (ADS). Remember, annual debt service is the total principal and interest for all mortgages.
Net Operating
Income = Debt
Coverage Ratio or NOI
= DCR
Annual Debt Service ADS
Example: Observe the following cash flow model for Before-Tax Cash Flow.
1. GROSS SCHEDULED INCOME $ 24,000
2. – Vacancy & Uncollected Rents – $ _ 1,200
3. = EFFECTIVE RENTAL INCOME = $ 22,800
4. + Other Income + $_ 400
5. = GROSS OPERATING INCOME = $ 23,200
6. – Annual Operating Expenses – $ 4,800
7. = NET OPERATING INCOME = $ 18,400
8. – Annual Debt Service – $ 13,428__
9. = BEFORE TAX CASH FLOW = $ 4,972
What is the before-tax cash flow? ________________
(Bottom line of the before-tax cash flow model)
What is the gross rent
multiplier for this investment? __________
(Purchase price divided by gross scheduled income)
What is the
capitalization rate for this investment? ___________
Net Operating
Income (NOI) = Cap Rate
Purchase Price
What is the cash on
cash return on this investment? ____________
Before-tax cash
flow = %
Return
Initial investment
What is the debt
coverage ratio for this investment? ____________
Net Operating
Income =
Debt Coverage Ratio
Annual Debt Service
OBTAINING
ACCURATE DATA
Obviously, your cash-flow
analysis will only be as accurate as the information you plug into the
cash flow model. Current information on a property's income and
expenses may be available from the following sources:
-
The property manager's records
-
Copies of the current lease and rental agreements
-
A copy of the owner's Schedule E (rental property income tax schedule)
-
The owner's personal records
Important Questions to
Ask
Gross Scheduled Income
-
What are the current rents, according to the lease and rental agreements?
-
Are these market rents?
-
How long do these agreements run?
-
Are the tenants prompt payers?
-
When were rents last increased?
-
What did the owner report as rental income on his Schedule E?
-
If there is a property manager, what do his records show as collected rents?
Vacancy & Uncollected Rents
-
What is the current vacancy factor for the property?
-
What is the current market or sub market vacancy factor?
-
What is a reasonable forecast for future vacancies?
-
Is the property competitive, or does it need to be upgraded?
Other Income
-
Are the laundry and vending machines owned by (a) the property owner or (b) an outside vendor?
-
If (a), how long will the machines last, and how much will it cost to replace them?
-
If (b), what are the contract terms?
-
Are parking fees charged for extra or large vehicles?
Annual Operating
Expenses
Annual expenses should be
broken down into categories. This will assist a buyer and his or her
tax professional to properly analyze the property. In addition it
makes it easy to enter the expenses on a Schedule E at tax time. The
following is a typical breakdown of annual expenses:
· Advertising
· Cleaning
and maintenance
· Leasing
commissions
· Property
insurance
· Legal
and other professional fees
· Management
fees
· Repairs
· Services
(garbage, gardening, pest, pool, landscaping,
etc.)
· Supplies
· Taxes
· Utilities
· Other
Annual Debt Service
Remember to include
only principal and interest payments; taxes and insurance have already
been accounted for under operating expenses.
Putting It All Together
So far we have learned to:
-
Gather accurate data
-
Calculate before- and after-tax cash flow
-
Use a Gross Rent Multiplier to determine the value of a property
-
Use Cap Rate to determine the value of an investment property
-
Calculate Cash on Cash
-
Calculate a Debt Coverage Ratio
Review
To reinforce what we have
learned so far, we will use the entire cash flow model to answer the
following questions:
-
What is the total initial investment?
-
What is the before-tax cash flow?
-
What is the gross rent multiplier for this investment?
-
What is the capitalization rate for this investment?
-
What is the cash on cash return on this investment?
-
What is the debt coverage ratio for this investment?
-
What is the after-tax cash flow?
Case Study
A ten-unit property is
listed for $465,000. It has five 1bd/1ba units rented at $500/month
and five 2bd/1ba units rented for $600/month.
The average vacancy in
the area is reported to be 5%. $1,100 per year in other income is
expected. Property taxes will be 1.2% of sales price/year. Insurance
will cost $1,800/year. Maintenance averages $2,500/year. Total
utilities will cost $2,600/year. Total services will cost $5,000/year.
Property management will cost 7% of Gross Operating Income. Buyer will
pay one point for 80% financing at 7.5% fixed rate amortized over 30
years with annual P&I payments totaling $31,213. Closing costs
will be 1.5% of sales price. Mortgage interest for year one will be
$27,784. Cost recovery will be $13,158. Annual points amortization
will be $124.00. Use 28% as the investor's tax bracket.
1. GROSS SCHEDULED INCOME $
2. – Vacancy & Uncollected Rents – $ ___________
3. = EFFECTIVE RENTAL INCOME = $
4. + Other Income + $___________
5. = GROSS OPERATING INCOME = $
6. – Annual Operating Expenses – $___________
7. = NET OPERATING INCOME = $
8. – Annual Debt Service – $___________
9. = BEFORE-TAX CASH FLOW = $
Tax Aspects of Cash Flow
10. NET OPERATING INCOME (LINE 7) $
11. - Interest (Mortgage 1) - $
12. - Interest (Mortgage 2) - $
13. - Points Amortization - $
14. - Cost Recovery (Depreciation) - $____________
15. = REAL ESTATE TAXABLE INCOME = $
16. x Investor's Tax Bracket x %___________
17. = TAX LIABILITY OR (SAVINGS) = $
After-Tax Cash Flow
18. BEFORE-TAX CASH FLOW (LINE 9) $
19. - Tax Liability or (Savings) (line 17) - $____________ + or (-)
20. = AFTER-TAX CASH FLOW = $
What is the total
initial investment?________________
(Down payment plus closing
costs plus points.)
What is the before-tax
cash flow? ________________
(Line 9 of the cash flow
model)
What is the gross rent
multiplier for this investment? __________
(Purchase price divided by
gross scheduled income)
What is the capitalization rate for this investment? ___________
Net Operating
Income (NOI) = Cap Rate
Purchase Price
What is the cash on cash return on this investment? ____________
Before-tax cash
flow = % Return
Initial investment
What is the debt
coverage ratio for this investment? ____________
Net Operating
Income =
Debt Coverage Ratio
Annual Debt Service
What is the after-tax
cash flow for this investment? _____________
(Bottom line of the
after-tax cash flow model.)
Information contained on this page provided by Wandering Star, with permission.
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Copyright © 2004 - 2009 The Molinaro Group
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